What lies ahead for mixed-use development?
Four members of ULI’s Urban Development/Mixed Use councils speak about the trends affecting urban mixed-use development, including the near-term prospects for development, the best sources for obtaining financing, and getting the right mix of uses.
Contributing their insights are Tadd Miller, principal of Milhaus Development in Indianapolis and program vice chair of the Urban Development/Mixed Use Council (Bronze Flight); Trey Morsbach, senior managing director of Holliday Fenoglio Fowler L.P. in Dallas and assistant chair of the Urban Development/Mixed Use Council (Green Flight); Alex Twining, president and CEO of Twining Properties in New York City and chair of the Urban Development/Mixed Use Council (Red Flight); and David Wall, president of GLL Development & Management in Walnut Creek, California, and a member of the Urban Development/Mixed Use Council (Silver Flight).
What are the prospects for urban mixed-use projects in the next few years?
Tadd Miller: It continues to be positive because of demographic trends and the way people want to live now. I live in downtown Indianapolis. Fifteen years ago, I don’t think many people would have been caught dead living in downtown Indianapolis by choice, and now it is the number-one market in our city. If you combine recent college graduates, which is a huge wave demographically, with the empty nesters, the movement back to the city is larger than the move to the suburbs was after World War II. There’s a desire to live more sustainably. All these trends require mixed-use development—from a land cost and construction cost perspective, and in order to meet today’s sustainability and consumer preferences.
David Wall: The prospects for mixed-use development in the next few years are somewhat limited. It will be slow because the driver of our economy is jobs. I’m hoping to see jobs pick up toward the middle or the end of 2011 and into 2012, so I believe that we’ll start seeing, in the next several years, more demand for mixed-use office/retail development, possibly with hotels. The timing isn’t right yet. It all depends on the economy.
Trey Morsbach: Six months ago, the world didn’t want to hear anything about development. Now there are a fair amount of multifamily projects being talked about or kicked off the ground. That is not unexpected: multifamily usually comes back first, and then other projects gain momentum. I think the near-term opportunities for the next 12 to 24 months are going to be in the acquisition, redevelopment, and reprogramming of existing broken mixed-use projects. Mixed-use development could happen if the site is right, but I think that will be the exception rather than the rule. There are so many projects that are getting taken back by the bank, and the banks are finally willing to sell at the right basis where a developer can come in and say: the infrastructure is broken, the rent stream is broken, the tenant mix is broken, but at this basis, I can fix it. In some cases, it can be as simple as resetting rents; in others, it can be as drastic as reprogramming the mix of uses, tearing down structures, and adding other uses.
How much does 2011 look different from 2010 in terms of obtaining capital/equity?
Morsbach: 2011 will most certainly be better. That has a lot more to do with what’s going on at the macro level of capital markets than it is about mixed use specifically. But for 2011, there is robust capital available for commercial real estate.
Alex Twining: There is a huge amount of equity capital that’s been sitting on the sidelines waiting to invest because people have been waiting for recession pricing, waiting for the big buy. Now, sales of operating properties are starting to happen, and they’re coming in at very high prices, so people are scratching their heads, saying, ” recession pricing?”
Miller: I don’t think the deal terms have really changed a lot from 2010 to 2011. What changed is the amount of capital seeking a home instead of sitting on the sidelines. For a good developer who has raised real equity of 25 percent and has a reasonable or stable balance sheet, the money is not that difficult to get. The bigger problem is it’s taken a long time for sellers to get realistic about taking their losses and for developers to get realistic about their pro forma. I don’t think we can blame it on the banks. It took developers time to get our balance sheets cleaned up and to realize that we are going to have to be realistic about fees and realistic about cap rates. We are not going to have the 12-, 18-, or 24-month exit on a 100- or 200-basis-point spread. For developers who realized that, there’s more equity out there than we can find projects to invest in.
Wall: If I had gone to some capital sources a year ago and said, I want to talk to you about building spec, they would have laughed and asked me, “What are you on?” Recently, I’ve been talking to a few people about partnerships on a potential development project, and I’ve discussed with them the possibility of going spec. They said, “Let’s sit down and discuss it.” Whether we end up doing spec or not, no one knows. But I believe strongly that the market will come back, jobs will be back, growth will come back, the demand will be there in certain key cities. Some of the equity players are more interested in becoming partners in 2011 compared to 2010. The capital will go to the more experienced relationships with experienced developers. On the lending side, banks and other lenders are going to be very conservative. They are going to want some preleasing or at least some substantial guarantees.
What kinds of financing challenges remain?
Twining: The most available capital for new mixed-use development projects is opportunity capital—investors who aim to get in, get out, make a return, and move on. The disconnect is that mixed use is more complex than other product types: it’s something a developer/operator would typically want to hold on to longer. So while there’s tons of that type of capital, it’s not necessarily the best capital for the product type. Core capital investors are for the most part still not playing in development at all. Some core pension funds are starting to see the value-add potential of acquiring properties; the problem is that they are looking to fill a pocket to meet regional or product goals, such as investing in housing on the East Coast or office space in the Midwest, so it’s not as clean to buy something with multiple uses. On the construction debt side, that’s going from nonexistent a year ago to available today—with a massive pound of flesh from the developer. So many deals have blown up that construction lenders are reluctant to give money even to blue-chip developers.
Morsbach: Capital sources are still fairly resistant to mixed-use projects because they got burned so bad in the downturn. Three or four years ago, mixed use was the darling of the commercial real estate world, and a lot of people forced mixed use into developments that may not have justified it. There were so many failures because mixed use is not easy to do. It’s easy to develop a grocery-centered retail center, and it’s pretty easy to develop multifamily, but it’s tough to integrate different uses, in terms of cost, design, and complementary uses, and not many people got it right. So a lot of capital sources played that game and got burned big time. Some projects have traded at a more than 50 to 60 percent discount to basis/cost. So people are very wary to step into a situation unless it’s either bulletproof or the basis is appropriate, where a developer can take over a distressed property and reprogram it.
Do you see certain types of mixes as having the most potential in 2011 and beyond?
Wall: Lifestyle mixes have the most potential. I think office/retail or office/retail/hotel still has potential in the Bay Area. The office/retail/condo concept residential is going to be a little slower only because of the slow residential market. But people are still attracted to the urban lifestyle, so depending upon the quality of the project, its location, the mix of uses, condos could still be very attractive. I think entertainment/lifestyle centers will still work well.
Miller: Residential is definitely the driving force because it is a market favorite right now. It is also hard to make land pricing and zoning approvals work for retail projects without the residential component. On a small scale, we’ll also see more local neighborhood mixed use, which may include some subsidized retail as a residential amenity. Other than in maybe Washington, D.C., and a couple of other markets like that, office or retail won’t drive much of the mixed-use development.
Morsbach: The simple answer is no, because it’s market specific and location specific. There could be a site where office above some retail makes the most sense because it’s a very urban location—say, New York City. Or there might be a site or location where multifamily makes a lot of sense and having the right programming of some kind of retail/entertainment is the right mix. I don’t think you’re going to see any hotel development of any note in the near future, but hotels in some cases are complementary uses for these projects.
Twining: Residential is usually the backbone of these projects, and then it depends, micromarket by micromarket, whether somebody wants to take a classic risk of a hotel, which in a very strong market may be worth it, or an office component. Whether you’re doing a stand-alone office building or an office that’s a major part of the mixed-use development, it’s probably not going to happen unless it’s fairly well-leased with a major anchor. So that can slow things down. Residential/retail deals are more likely.
What other trends in urban mixed use do you see ahead?
Miller: The biggest game changer is public/private partnerships unlike any we’ve ever seen. Developers have always had some need for municipal involvement in large-scale mixed-use projects. But now, in certain situations, private companies can borrow more cheaply than governments, and governments are getting access to complicated financial structures and new streams of federal dollars. Some states and municipalities are actually borrowing money from private developers in exchange for guarantees. These trends are changing the entire business model, specifically for large-scale mixed-use projects.
Twining: Most of the major REITs [real estate investment trusts] have significant amounts of capital, but they typically don’t include retail. They’ll put retail at the bottom of a building, but they really don’t want to do mixed-use development because it takes them outside of the main product type that they’re supposed to be attending to for their shareholders. So a multiblock mixed-use precinct can be attractive to REITs. They can stay within their silo of expertise but take advantage of having their buildings next door to the other uses. Funding for the other buildings can come from other sources. One developer builds an office building above retail, and then across the street another developer builds residential and retail, all in the same complex. I’m talking specifically about entitled multiblock mixed-use deals that got entitled in the last real estate cycle. For example, in Boston, two of the bigger ones are Seaport Square and Assembly Square. Those are both ripe for that kind of development. I think that trend will continue.
Wall: One trend will be the social/interactive aspect. Think of Facebook, the millions of people that are on it, then convert that sort of thinking into a new development. I think that’s where we’re headed. For example, more central meeting places for people. In the project I’m trying to develop in downtown San Francisco, we are not only creating a public lobby at street level, with a café and restaurant, but we are also making it interactive. For example, if you walk by the project and you have your location service on, something will come up on your screen and invite you in to take a look. In the lobby, stanchions with interactive modules will provide information such as the building’s carbon footprint, when the next train or bus is coming. I think we’re going to see more of that: whether in mixed use, residential, or retail, this is what people are really wanting.